Insurance and investing are two critical components of any solid financial plan. A robust savings and investment strategy can compound your wealth over time. And comprehensive insurance coverages can protect your wealth and keep you and your family from having to face life-altering financial circumstances if the worst ever comes to pass.
However, mixing insurance with investing can create a recipe for disaster. Here are a few reasons why:
#1 – Designed to be sold
There is a huge variety of products that combine insurance and investing, but they generally fall into two broad categories: cash value life insurance and variable annuities.
Now, here’s something interesting to think about… these products are designed to be sold. What does that mean? Well, these products tend to offer very limited utility to the consumer. But they offer tremendous utility (in the form of profits) to insurance companies. So who has more incentive to engage in a transaction? The insurance company and their sales force.
This is in contrast to a product designed to be bought, such as emergency medical services. For example, if your arm falls off, you have a lot incentive to go find a doctor! That doctor doesn’t have to lift a finger to sell their services.
When it comes to our finances, we should always be wary of any product that is designed to be sold.
#2 – Complexity
Have you ever actually read through a policy document for a cash value life insurance policy or variable annuity? Most of these documents run 50-100+ pages and contain a large amount of financial jargon. They are not easy to read, even for financial professionals, much less the lawyers that no doubt authored them. Insurance companies know that very few people have the time, inclination, or grit to wade through the muck of the policy terms and conditions, so they often include lots of complexity on purpose. This complexity muddies the waters and allows an insurance company to stack the deck in their favor at the expense of the customer.
One example of this comes from up-front or “teaser” structured annuity rates. When the customer buys the product, the insurance company guarantees a certain payout structure for a certain period of time. But reading through the policy document, it’s often the case that the insurance company will reserve the right to adjust this guarantee to basically whatever they want! The customer often ends up overpaying for an ephemeral guarantee.
#2 – Higher insurance costs
There is a concept in economics known as commoditization. A commodity product is non-specialized… it looks a lot like the products offered by the competition. For example, the oil that Exxon pulls out of the ground is pretty much the same as the oil that Chevron pulls of the the ground. This product similarity only allows for competition in one arena… price.
Non-investment insurance products like term life insurance are also commodity products. These days we can get about 20 quotes for term life insurance in 10 seconds, so competition helps keep a lid on prices for customers. However, since cash value life insurance and variable annuities incorporate complexity by design, they can break away from the commodity-based pricing regime. This results in higher prices for customers. After all, if you can’t price check your variable annuity because it’s so complex and different from every other variable annuity, how will you know if you’re getting a fair deal?
#3 – Higher investment fees
Cash value life insurance or variable annuities also do a great job of increasing investment fees. The Vanguard S&P 500 ETF has an expense ratio of 0.03%. It’s not unusual for comparable investment options inside insurance products to approach or exceed 1.00%. These days, that just doesn’t make sense for any reason except to enrich the insurance company and the asset manager.
#4 – The tax benefits are overrated
Cash value life insurance and variable annuities are often pitched as a way to manage tax exposure. Investments inside these products can often grow on a tax-deferred basis, similar to a Traditional IRA/401(k).
However, if you want tax deferral, why not just use an IRA/401(k) plan (or HSA)? If you haven’t maxed out contributions to your IRA, 401(k), and HSA, then there is no marginal tax benefit to investing in a life insurance or variable annuity product. In fact, IRAs/401(k)s/HSAs are even better from a tax standpoint. You get tax-deferred growth and an upfront tax deduction. Neither life insurance or variable annuities allows you to deduct contributions up front.
It’s also common to see variable annuities purchased within a customer’s IRA. When this happens, the variable annuity adds exactly zero tax benefit as the IRA is already doing the heavy lifting.
#5 – Loss of liquidity
Liquidity has value. If you invest in the stock market, you can generally “cash out” within two business days. So if you need money, you don’t need to wait very long.
But when you buy an insurance product, the sales team gets an upfront commission. And these commissions can be very high. But what if a customer wants to cancel the policy and cash it out? Well, the insurance company just paid their salesperson a lot of money so they need to earn enough from the policy to justify paying the commission. As a result, cash value life insurance and variable annuities almost always incorporate surrender charges to steer people away from cancelling the policy. I’ve seen surrender charge schedules that run 6+ years, which means you often can’t touch your money for a long time.
#6 – Ignoring the need for insurance
As people go through life, their need for insurance changes. For example, a 30-year old doctor with a wife, three kids, and zero assets needs a lot of life and disability insurance. However, that same doctor probably doesn’t need any life or disability insurance when he retires.
If you don’t need life insurance, then why should you own a life insurance policy?
In conclusion, don’t mix insurance with investing and you’ll likely be better off in the long run. Don’t forget to purchase appropriate insurance coverages and develop a solid investment plan, but don’t let an insurance salesperson convince you to combine them without thinking long and hard about the potential costs and consequences.
